Kat Martin, the CFO of Kelley Power Products (KPP) has requested your assistance in evaluating a capital budgeting proposal. The proposal involves the production of a new line of gearboxes for use in heavy freight applications. Research and development costs to develop this new line of gearboxes were $320,000 last year (2019). Production of the new product would require investment in new machinery. The machinery to be purchased would cost $6,000,000, and would have a useful life of 5 years. KPP has conferred with its tax accountant and has been informed that they must depreciate the machinery straight-line for a 4-year period to a value of 0. The machinery is expected to be sold for a market value of $500,000 at the end of the 5th year. Management expects to sell 5,000 gearboxes in years 1 and 2, and 6,000 gearboxes in each of the remaining three years. The sales price per gearbox is projected to be $1000 in year one, and management believes that the sales price will increase by 2% per year over the life of the project. Variable production costs are projected to be $600 per gearbox in year one and management expects these costs to increase by 2% per year over the life of the project. Fixed production costs are expected to be $150,000 in the first year and each remaining year of the project. If the new line of gearboxes is produced, KPP will need to make additional investments in Net Working Capital (NWC) to support the increased operations.The increase in NWC (at time t) is expected to be 20% of incremental sales between time t and time t+1. Thus, the NWC investment required (or change in NWC) at t=0 would be 20% of the projected sales for t=1. Additional NWC investments would be required to support any further increases in sales and the cumulative investment in NWC made as a result of this project would be completely recovered at the project's end (NWC levels will return to 0). The discount rate used to evaluate this project is 11%, and the relevant tax rate is 25%. Develop the incremental cash flow projections for this proposal. Make sure to clearly identify (1) incremental operating cash flows, (2) NWC Investment cash flows, (3) net capital spending, and then, (4) sum these three figures to get free cash flow or cash flow from assets. Next, use the projected free cash flows to calculate the project's NPV and IRR.

Question

Kat Martin, the CFO of Kelley Power Products (KPP) has requested your assistance in evaluating a capital budgeting
proposal. The proposal involves the production of a new line of gearboxes for use in heavy freight applications. Research
and development costs to develop this new line of gearboxes were $320,000 last year (2019). Production of the new
product would require investment in new machinery. The machinery to be purchased would cost $6,000,000, and would
have a useful life of 5 years. KPP has conferred with its tax accountant and has been informed that they must depreciate
the machinery straight-line for a 4-year period to a value of 0. The machinery is expected to be sold for a market value of
$500,000 at the end of the 5th year.
Management expects to sell 5,000 gearboxes in years 1 and 2, and 6,000 gearboxes in each of the remaining three years.
The sales price per gearbox is projected to be $1000 in year one, and management believes that the sales price will
increase by 2% per year over the life of the project. Variable production costs are projected to be $600 per gearbox in year
one and management expects these costs to increase by 2% per year over the life of the project. Fixed production costs are
expected to be $150,000 in the first year and each remaining year of the project. If the new line of gearboxes is produced,
KPP will need to make additional investments in Net Working Capital (NWC) to support the increased operations.The
increase in NWC (at time t) is expected to be 20% of incremental sales between time t and time t+1. Thus, the NWC
investment required (or change in NWC) at t=0 would be 20% of the projected sales for t=1. Additional NWC investments
would be required to support any further increases in sales and the cumulative investment in NWC made as a result of this
project would be completely recovered at the project's end (NWC levels will return to 0). The discount rate used to
evaluate this project is 11%, and the relevant tax rate is 25%.
Develop the incremental cash flow projections for this proposal. Make sure to clearly identify (1) incremental
operating cash flows, (2) NWC Investment cash flows, (3) net capital spending, and then, (4) sum these three
figures to get free cash flow or cash flow from assets. Next, use the projected free cash flows to calculate the
project's NPV and IRR.

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